'Flexibility' New Fed Buzzword

The Federal Reserve did itself a favor by not locking itself into a fixed timeline for raising interest rates.

The U.S. economy in recent months – recent years, actually – while generally trending upward, has zigged and zagged and no one seems to have a clue as to when it will gain the kind of sustained momentum that will support higher borrowing costs. Since the beginning of 2015 the data has been especially messy, leaving analysts and economists baffled as to when the Fed might raise rates.

Fed policy makers don’t know either. San Francisco Federal Reserve President John C. Williams earlier this week emphasized the importance of not jumping to conclusions or making policy decisions “based on noisy data.”

For months the Fed used the word ‘patience’ to describe its stance toward a rate hike. Having lost ‘patience’ in March, the new buzzword is ‘flexible.’ As used by the Fed, the terms are essentially synonymous. But get used to hearing ‘flexible.’ It’s going to be around for a while.

The Fed has long preached flexibility with regard to normalizing monetary policy after years of unprecedented stimulus, and given the roller-coaster nature of the recovery that strategy has proven prescient.

It might have been tempting late last year to all but lock in a rate hike for mid-2015 following 5% GDP growth in the third quarter and a string of solid employment reports throughout 2014, not least November figures that revealed a whopping 353,000 new jobs. In all, 2014 was the strongest year for job creation since 1999.

Cracks in the Facade

But there were always cracks in the façade, namely weak wage growth that has curbed consumer spending and kept inflation well below the Fed’s 2% target rate. Combine that with a strong dollar that has hurt U.S. exports and falling oil prices that cut into profits across the bellwether energy sector. Then throw in temporary factors such as another harsh winter and a dock strike in California that disrupted distribution channels and the result has been a sharp slowdown in economic growth so far in 2015.

First quarter GDP growth came in at 0.2% and that number is widely expected to be revised downward as a string of data reports released in recent days have suggested the economy probably contracted during the first three months of the year.

The April jobs report released Friday showed the labor market bounced back a bit from a shockingly weak March, but wages remained stuck in neutral.

“Some have described Friday’s employment report as pointing to a ‘Goldilocks’ economy: not too hot and not too cold.  However, in truth, the American economy of 2015 is more like Goldilocks’ Grandmother: not too hot, not too cold….and not too fast,” said David Kelly, chief global strategist at J.P. Morgan Funds.

Kelly believes the first-quarter GDP numbers “are likely understating real economic momentum” and that long-term labor market trends suggest the job market will continue to tighten. In other words, the economy is slowly but surely strengthening, a situation that will likely allow for a rate hike before the end of the year.

Maybe, but maybe not.

In any case, the Fed seems to have learned its lesson about the need to maintain flexibility during an unpredictable economic recovery.

Two years ago the Ben Bernanke-run central bank appeared to prematurely commit to a fixed timeline for raising rates only to have to walk away from that commitment when economic conditions shifted.

Throughout 2013 the Fed targeted 6.5% unemployment as a threshold for raising the key fed funds interest rate above its current near-zero level, where it was lowered in December 2008 during the height of the financial crisis.

The 6.5% jobless rate threshold had been held out as a target that would provide evidence the economy was healing and ready to begin standing on its own without the unprecedented stimulus policies initiated by the Fed in the wake of the 2008 financial crisis.

But a funny thing happened on the way to 6.5%.

Commitment to Flexibility

The inflation rate, which was supposed to soar as a result of all those trillions of easy Fed dollars pumped into the financial system via bond purchases and low interest rates, has remained stubbornly below the Fed’s 2% target rate.

In early 2014, as it became clear that the unemployment rate would fall below the 6.5% unemployment threshold long before inflation would approach 2%, the Fed was forced to backtrack on its fixed timetable for raising rates.

Since then central bankers have studiously avoided leaving any impression that they are setting timetables tied to economic thresholds, and ‘flexibility’ has been at the center of their revised mantra.

When rates move higher so will the cost of buying big ticket items such as homes and cars, forcing some consumers to back off those purchases. It will also make it more expensive for businesses to borrow money for expansion and investment in new capital, which could impact hiring. That’s why central bankers have been reluctant to raise rates from the historic lows where they’ve been held for over six years.

Influential Fed policy makers such as New York Fed President William Dudley and Chicago Fed President Charles Evans have made it clear – repeatedly – that the timing of a rate hike will be data-dependent. In other words, nothing is going to happen until the data justifies a move.

The minutes from the March meeting of the policy-setting Federal Open Markets Committee also reaffirmed this commitment to flexibility: “With continued improvement in economic conditions, they preferred language that would provide the Committee with the flexibility to subsequently adjust the target range for the federal funds rate on a meeting-by-meeting basis.” Expect the next few statements to loudly and clearly reiterate that message.